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Wednesday, September 25, 2013

What the RBI did and did not do right

In times of economic crisis, it is easier to target the
State's financial institutions, of which the most influential and powerful is
the Central Bank. In case of the Indian economy, the Reserve Bank of India
(RBI) has been at the receiving end of criticism, as well as some praise, for
the way in which it has so far handled the economic storms of 2012-13. Before
we can pass judgment on how correct RBI's measures were, we need to take a look
at what the key issues were, and what were the limitations on the RBI's powers.

All of these contributing to falling GDP, which in
turn compounded these problems.

Of these, the RBI could do little to alter the commodity
markets themselves, industrial growth, the fiscal problem or the political
issues. The remainder of the article will, therefore, be dedicated to analyzing
RBI's measures in handling the other problems i.e. High CAD, inflation, the
rupee's health and the disappearance of foreign capital, while trying to ensure
financial stability, currency stability and inclusive growth.

Increase of repo rates (mid 2012 to early 2013)
– Governor Subbarao had followed a policy of raising the repo rates
continuously during 2010-12, citing the rising inflation. Since repo rates
directly impacted growth, Subbarao argued that mid-term price stability
had to be achieved at the cost of sacrificing short term growth.Subbarao continued to raise rates even
when inflation had moderated at 8.9% levels. By March 2012, repo rates
were at a high of 8.5%, and growth had slowed to a decadal low. In sum,
Subbarao's continuation of rate increases even after inflation had stabilized
did more harm than good to the Indian economy.

The CAD problem (late 2012-present) – By
late 2012, it was evident that CAD (Current Account Deficit) was rising
alarmingly on the back of growing trade deficit. This finally forced RBI
to change its stance, with reduction of repo from 8.5% down to 7.25% in
the early months of 2013. However, industrial productivity remained stagnant,
and critics called the rate of reduction as too slow to help the issue. In
fact, even now, inflation remained the single-most overriding issue in the
minds of RBI mandarins. The end result was that GDP growth tumbled still
further, ending up at 5%.

To its credit, however, RBI correctly gauged the reasons for the
burgeoning CAD – rising oil import prices, and rising
gold imports. To this end, it sought to limit the imports of gold into
the country in July. This included the requirement that every certified
gold importer must set aside 20% of every lot imported such that it “is
exclusively made available for the purpose of export”. Critics warned that
this would constitute an export bias in the jewellery industry at a time
when global markets were not favorable. Further, high demand would lead to
rise in smuggling and grey market activity. On the other hand, the role of
RBI's gold control measure on CAD is a matter of debate.

The fall of the rupee (August-September 2013) – As
rumors of a potential rollback of the QE3 liquidity stimulus by the US Fed
sent FIIs scurrying for US shores, the
stock market began to take a serious beating, with ominous signs of an
impending financial crisis in the horizon. Even worse, the rupee
began to collapse due to heavy selling by foreign investors. From
around 60 to the dollar, it reached 69 in the second half of August. The
RBI sought to allay markets by selling dollars. Further, it provided
dollars out of its reserves to the oil PSUs, which together account for about
40% of the dollar demand. This had a strong positive impact on markets and
aided the stabilization of the rupee at the 65-level.

The RBI also simplified rules for investment by NRIs. Though its immediate
impact in arresting the rupee's slide is debatable, it was hailed by the
market as a step in the right direction.

Latest measures (September 2013) – The present
month has seen two significant developments – a change of guard at the
RBI, with Subbarao being replaced by Raghuram Rajan, and the surprising
announcement by Ben Bernanke that the QE3, in fact, would not be rolled
back. This means that emerging Asian markets like India can continue to
benefit from foreign investments for the time being, and this has gone a
long way in lifting the gloom.

Rajan has taken advantage of the resultant market
rally to raise the repo rates by 0.25%. This, while surprising many (who had
expected a drop considering the change of financial winds), appears to be aimed
at curbing inflation. Unlike before, the situation, with stabilizing oil prices
allowing CAD to stay within bounds, rupee stabilizing and markets shedding
their bearish nature to some extent, appears more favorable for tackling
inflation through monetary policy. Whether it will succeed, however, is difficult
to say.

As the above study of the major crises and the RBI's reactions
show, the Central Bank showed a continued, sometimes uncanny, concern for
inflation. While controlling inflation is no doubt important, excessive focus
on this factor robbed the RBI of opportunities for spurring growth. On the
other hand, it should be remembered (as we mentioned at the beginning), that
RBI does not control allfactors, and
the Finance Ministry's measures, sometimes at loggerheads with the RBI, along
with domestic and international factors, often complicated matters.

That Subbarao, and then Rajan, managed to come out with
measures like simplification of investment norms for NRIs, is in itself
commendable. Therefore, while it must be accepted that the RBI made more
mistakes than it should have, blaming India's economic predicament solely on
the RBI would be doing injustice to India's central bank.